Accounting Theory

Modifying conventions (or constraints)

In certain instances, companies do not strictly apply accounting principles because of modifying conventions (or constraints). Modifying conventions are customs emerging from accounting practice that alter the results obtained from a strict application of accounting principles. Three modifying conventions are cost-benefit, materiality, and conservatism.

Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including optional information in financial statements exceed the costs of providing the information. Users tend to think information is cost free since they incur none of the costs of providing the information. Preparers realize that providing information is costly. The benefits of using information should exceed the costs of providing it. The measurement of benefits is inexact, which makes application of this modifying convention difficult in practice.

Materiality Materiality is a modifying convention that allows accountants to deal with immaterial (unimportant) items in an expedient but theoretically incorrect manner. The fundamental question accountants must ask in judging the materiality of an item is whether a knowledgeable user's decisions would be different if the information were presented in the theoretically correct manner. If not, the item is immaterial and may be reported in a theoretically incorrect but expedient manner. For instance, because inexpensive items such as calculators often do not make a difference in a statement user's decision to invest in the company, they are immaterial (unimportant) and may be expensed when purchased. However, because expensive items such as mainframe computers usually do make a difference in such a decision, they are material (important) and should be recorded as assets and depreciated. Accountants should record all material items in a theoretically correct manner. They may record immaterial items in a theoretically incorrect manner simply because it is more convenient and less expensive to do so. For example, they may debit the cost of a wastebasket to an expense account rather than an asset account even though the wastebasket has an expected useful life of 30 years. It simply is not worth the cost of recording depreciation expense on such a small item over its life.

The FASB defines materiality as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement". The term magnitude in this definition suggests that the materiality of an item may be assessed by looking at its relative size. A USD 10,000 error in an expense in a company with earnings of USD 30,000 is material. The same error in a company earning USD 30,000,000 may not be material.

Materiality involves more than the relative dollar amounts. Often the nature of the item makes it material. For example, it may be quite significant to know that a company is paying bribes or making illegal political contributions, even if the dollar amounts of such items are relatively small.

Conservatism Conservatism means being cautious or prudent and making sure that assets and net income are not overstated. Such overstatements can mislead potential investors in the company and creditors making loans to the company. We apply conservatism when the lower-of-cost-or-market rule is used for inventory (see Chapter 7). Accountants must realize a fine line exists between conservative and incorrect accounting.

See Exhibit 30 for a summary of the modifying conventions and their importance. The next section of this chapter discusses the conceptual framework project of the Financial Accounting Standards Board. The FASB designed the conceptual framework project to resolve some disagreements about the proper theoretical foundation for accounting. We present only the portions of the project relevant to this text. 

Description Importance
Exchange-price (or cost)
Requires transfers of resources to be recorded at prices to the exchange at the time of exchange.
Tells the accountant to record a transfer of resources at an objectively determinable amount at the time of exchange. Also, self-constructed assets are recorded at their actual cost rather than at some estimate of what they would have cost if they had been purchased.
Revenue recognition
Revenues should be earned and realized before they are recognized (recorded).
Informs accountant that revenues generally should be recognized when services are performed or goods are sold. Exceptions are made for items such as installment sales and long-term construction projects.
Expenses should be recognized (recorded) as they are incurred to produce revenues. Indicates that expenses are to be recorded as soon as they are incurred rather than waiting until some future time.
Gain and loss recognition
Gains may be recorded only when realized, but losses should be recorded when they first become evident.
Tells the accountant to be conservative when recognizing gains and losses. Gains can only be recognized when they have been realized through sale or exchange. Losses should be recognized as soon as they become evident. Thus, potential losses can be recorded, but only gains that have actually been realized can be recorded.
Full disclosure
Information important enough to influence the decisions of an informed user of the financial statements should be disclosed. disclose. Requires the accountant to disclose everything that is important. A good rule to follow is - if in doubt, disclosed. disclose. Another good rule is - if you are not consistent, disclose all the facts and the effect on income.

Exhibit 29: The major principles

Modifying Convention
Description Importance
Cost-benefit Optional information should be included financial statements only if the benefits providing it exceed its costs. Lets the accountant know that information that is not required should be made available only if its benefits exceed its costs. An example may be companies going to the expense of providing information on the effects of inflation when the inflation rate is low and/or users do not seem to benefit significantly from the information.
Materiality Only items that would affect a knowledgeable user's decision are material (important) and must be reported in a theoretically correct way. Allow accountants to treat immaterial (relatively small dollar amount) information in a theoretically incorrect but expedient manner. For instance, a wastebasket can be expensed rather than capitalized and depreciated even though it may last for 30 years.
Conservatism Transactions should be recorded so that assets and net income are not overstated. Warns accountants that assets and net income are not to be overstated. "Anticipate (and record) all possible losses and do not anticipate (or record) any possible gains" is common advice under this constraint. Also, conservative application of the matching principle involves making sure that adjustments for expenses for such items as uncollectible accounts, warranties, and depreciation are adequate.

Exhibit 30: Modifying conventions